First Person

An alarming déjà vu

Allister Heath — Thu, 28 Jul 2011 12:22:54 +0100

All the signals are still flashing red in the Eurozone, despite the recent muddled attempt at a bailout. It is feeling more and more like the middle of 2008, when a major financial crisis was already upon us yet the authorities remained convinced that half-measures would be enough to avoid catastrophe. The parallels today are eery; Britain's establishment is obsessed with the phone hacking scandal yet several European countries are moving closer to collapse, threatening to take down the UK economy with them.

Even before Lehman Brothers went bust, pushing the global economy to the brink, all the warning signs were already there for those with eyes to see. The Fed helped arrange the bailout of another major investment bank, Bear Stearns; numerous sub-prime lenders went under; America's state-backed giant mortgage lenders hit the rocks; and the credit markets started to panic. Just three years later, many senior players are privately warning that they detect exactly the same warning signs in the financial markets. Several countries are effectively insolvent, Ireland and Greece have been bailed out yet again but interest rates on Italian and Spanish government debt remain elevated, and financial institutions are becoming more reluctant to lend to weaker players.

Toxic governments and their junk debt are the new systemic threat to the world economy. Even though financial institutions and regulators are better prepared this time around, the crisis of 2011-13, as I suspect it will eventually be named, could still inflict massive devastation. London won't be spared as it remains at the centre of global finance and is the home to numerous European financial institutions.

This is not just about banks: insurance companies, pension funds, hedge funds, exchange-traded funds and a myriad of other kinds of companies and investment vehicles own government debt. They were encouraged or even forced to do so. The usual textbook assumption is that government debt - and especially the bonds issues by strong states - is risk-free. Because countries such as Greece, Italy and Spain are all members of the single currency, it was wrongly thought that their borrowing was as safe as Germany's - in other words, investors stupidly believed that everybody's debt was backed by the better-managed European countries, that the Eurozone was a fiscal union, not merely a monetary one.

Yet when institutions lent money to countries such as Greece, they were actually entrusting their money to sub-prime borrowers masquerading as high-quality sovereigns. For all the fiddling in recent days, this still feels like a re-run of 2008, albeit on an even larger scale. Catastrophe can still be avoided, but time is fast running out.

The coalition is failing to deliver

Allister Heath — Thu, 24 Feb 2011 10:25:49 +0000

You wouldn't believe it if your only source of news was the BBC, but the number of jobs in Britain actually went up last year.

Too many of the new positions were part-time, and young people are finding it horribly tough - but there was nevertheless a decent amount of job creation, a trend which is likely to continue this year.

Economics specialises in apparent paradoxes. The total number of people in employment rose by 218,000 to 29.12 million last year - but unemployment also went up by 40,000. The reason for this, of course, is that the number of people looking for work grew faster than the amount of new jobs. Insufficient job creation, rather than a jobless recovery, is the real danger.

The private sector created an extra 296,000 jobs last year, easily mopping up the 77,000 lost by the state.

But instead of doing more to encourage firms, the coalition is still increasing taxes and red tape. For all the claims that it is scrapping "Labour's tax on jobs", National Insurance is going up again in April. When one speaks to companies, especially small ones, the verdict is clear: the government is making it more expensive to hire people, so they are doing all they can to avoid committing to new staff.

The British Chamber of Commerce (BCC) calculates that new red tape - including regulations from the EU - will cost firms an extra £23 billion over the next four years. Seven major new rules are coming in this year alone. The coalition promised a bonfire of red tape, yet as a devastating report from the National Audit Office points out, it has utterly failed to deliver. David Cameron's "one in, one out" pledge on regulation is a major broken promise.

One issue the coalition is trying to tackle is the cost to firms of employment tribunals, now £1.6 billion a year. Employment legislation has become so complex that just one in twenty HR professionals fully understands the 'tribunal process. The average cost of settling is £5,400; employers who defend themselves pay £8,500.

The reforms proposed will redress the balance and reassure firms that the system is no longer open to abuse - but they are just one small step in the right direction.

Much more is required: unless the coalition takes an axe to the tax and red tape crippling employers, there is no way UK plc will be able or willing to create enough jobs for all.

Sorry, but it's time to put up interest rates

Allister Heath — Thu, 04 Nov 2010 16:27:48 +0000

Borrowers won't thank me for saying this but it is time for the Bank of England to start hiking interest rates.

The economy is recovering at a break-neck speed, inflation is far too high and savers are being wiped out by ridiculously low rates of interest. Andrew Sentance, the one hawkish member of the Bank of England's monetary policy committee (MPC), is spot on: we must start weaning ourselves off ultra-cheap money before we become truly addicted to it.

The data backs up my contention. The economy, which expanded by 0.8per cent in the third quarter, has already recovered 40 per cent of its loss incurred during the recession, a much speedier bounce than expected.

Even assuming that growth slows to 0.4 per cent in the fourth quarter, GDP will increase by 1.8 per cent in 2010, easily smashing the consensus forecast of 1.3 per cent made by economists at the start of the year.

This kind of growth rate means that there is no longer any excuse to keep interest rates so low.

The latest figures reveal that the expansion hit 2.8 per cent year on year. To put this into perspective, it is above the 1998-08 boom-time average of 2.6 per cent a year. The figures were substantially stronger than the MPC had expected. So it is no wonder that the Bank as also got it wrong on inflation.

Prices have been going up at a much faster rate than it expected, forcing Governor Mervyn King to repeatedly write letters of apology to George Osborne.

Even the consumer price index, the official measure of inflation, is now at 3.1 per cent. Inflation on the retail price index - the broadest measure of inflation, including mortgages – is running at 4.6 per cent per cent a year.

One reason why the economy did better than many feared in the third quarter is that most analysts have misunderstood what is happening to the money supply.

While the total amount of money in the economy as been growing at a sluggish rate, it has been circulating much more quickly, boosting demand.

Next year will be tough but the private sector's momentum should allow it to cope with public sector cuts; in fact, contrary to what many expect, these could even boost growth if they reassure companies that the UK is once again a safe place in which to invest.

All the talk from City economists about needing to indulge in yet more quantitative easing is therefore senseless. The debate needs to move on: it is time for the Bank to start hiking interest rates.

Coalition presents a mixed business bag

Allister Heath — Fri, 21 May 2010 14:22:41 +0100

Buy sterling, sell the euro: that was the rallying cry in the City as the news sunk in that the Tories and Lib Dems had formed a coalition.

A few weeks ago, most economists feared Britain was on the brink of a fiscal crisis; they are much more optimistic today, especially with both parties committed to a tough round of fiscal consolidation. As long as the coalition continues to send out the right signals, and that the emergency budget contains a plausible plan to slash the deficit, it will have the support of the financial markets.

But while the macro picture has improved substantially, the government has also announced a series of measures that will hit business and investors. The big question is: what will happen to the banks? Will they be reformed rationally and carefully? Or will they will they be vandalised in a frenzy of populism, with no regard to the damage this would do to Britain's prosperity? It may take a year to find out, thanks to the new banking commission to be run by George Osborne with Vince Cable's help.

Other problems include the fact that the Tory proposal to cancel Labour's planned "tax on jobs" has been further diluted. The Tory dream to cut corporation tax to 25 per cent also appears to have vanished. Heathrow's third runway, which had the support of all business groups, has been cancelled; there will be no further runways at Gatwick and Stansted. It is unclear where increased capacity will come from to meet growing demand for air travel; if supply is not increased, the price of flying will go up.

It is also disappointing that capital gains tax is going up, likely to 40 per cent. There will be exemptions for business assets and entrepreneurs, though we don't know how useful these will be, nor what will happen to private equity funds and how employees with stock options will be treated. But as David Cameron has said, the tax hike is in part intended to discourage investment in buy-to-let properties. The hikes will hit millions of small investors, the kinds of people that the Tories used to see as their core voters.

The good news for Cameron is that over the next few months, his bad micro policies will take second fiddle to the great, burning macro issue of our time: the budget deficit and his refreshingly strong approach to tackling it. Until the public finances are firmly back on track, those in the business community angered by the government's many anti-business policies are likely to keep their powder dry - or that, at least, that is what David Cameron will be banking on.

First Person: Time to worry about house prices

Allister Heath — Thu, 25 Feb 2010 14:06:01 +0000

It is time to start worrying about house prices again. The recovery in the property market over the past year makes little sense and could soon go into reverse again. Mortgage lending fell by a third in January and all objective measures suggest that housing remains thoroughly overvalued. A double-dip in the property market is one of the greatest risks facing British consumers, investors and the banking system. The downturns of the early 1990s and mid-1970s triggered dramatic property slumps. Real house prices fell 30 per cent and it took four years before they started recovering again, according to Lombard Street Research. This time around, inflation-adjusted prices bottomed out only 17 per cent below peak and begun rising after just 18 months.

This dramatic recovery - a "dead-cat bounce" - caught most economists by surprise. In many ways, this prompt housing recovery is a great thing: it has helped bolster consumer confidence, reduced the numbers of individuals facing bankruptcy and helped cushion the banking system from greater losses.

But it also means that our steeply over-valued market has not really readjusted, for two reasons. For those aged 25-49 - peak mortgage years - unemployment has risen to only 6.3 per cent, compared with peaks of 9-10 per cent in previous cycles. Rate cuts have also helped.

Only 12 per cent of households faced housing payment problems last year, against 20 per cent in 1991.

No asset can remain overvalued for ever. At best, house prices will stagnate for years, with inflation and higher wages eventually bringing valuations back into line with fundamentals without an actual crash. But it is equally possible that the market will suffer from outright falls again when rates start to go up. Just don't expect the mini-boom of recent months to continue.

Next year will be distinctly painful

Allister Heath — Tue, 29 Dec 2009 12:34:57 +0000

Let us start with the good news: it is almost inconceivable that the British economy won’t fare better in 2010 than it did in 2009.

We have just come out of the most severe recession since the 1930s, with our economy shrinking drastically; I would hate to tempt fate but there is little that could be thrown at us in the coming year that would precipitate another such dramatic contraction. Growth is likely to make a return; in fact, the economy almost certainly started expanding again in the last few months of 2009.

But apart from that, the outlook is pretty grim. The economy is facing a huge number of challenges. The banking system is working again (contrary to what most commentators are claiming) but economic growth will be weak — not only in the year ahead but for a long time to come. In the good years, we grew used to the economy expanding by close to 3 per cent every year; we will be lucky to get half that over the next 3-4 years. Unemployment will remain high; incomes growth will be subdued; taxes will go up; many firms will move out of the UK, as will many highly paid individuals; and the public sector will face its greatest squeeze since the end of the Second World War.

We have attempted to borrow ourselves out of a crisis caused by too much debt. One result of this has been the explosion in the budget deficit to around £180bn for the next couple of years, an extraordinarily imprudent state of affairs. Whoever wins the next election will have to slash public spending; if this doesn’t happen, or if we end up with a hung Parliament, we will face a real government debt crisis, with dire consequences for everybody in the UK.

Britain’s budget deficit has only been bearable to date thanks to quantitative easing, which has seen the Bank of England spend a fortune buying up all of the new gilts printed by the government to pay for its spending. At some point this year, the Bank will start to cut back on its purchases and the exchequer will have to convince private investors to start buying its debt. This will be tough; it will require higher interest rates on UK gilts, which in turn will mean a higher cost of borrowing across the economy.

Given how weak the private sector still is, and the fact that so many households have yet to pay down their mortgages and credit card bills, higher interest rates will prove painful. But they will become unavoidable for another reason: inflation is making a return and will soon require firm action. Quantitative easing has led to a collapse in sterling, driving up consumer prices.

At least higher interest rates will start encouraging people to put more money aside and cease penalising savers. But shoppers will have to cut back further and the housing market will also suffer. One of the great false dawns of 2009 was the housing market: the great property crash is not over yet. The six to seven per cent bounce back in prices in recent months lacked all justification; prices could easily fall by another tenth or so next year. This is one of the greatest risks facing the UK: banks could be hit by another wave of write-offs, causing real damage.

The coming year won’t be as tough as 2009 — but only just. Anybody hoping for an easy ride is going to be in for a rude awakening.

Darling, take an axe to public spending

Allister Heath — Wed, 09 Dec 2009 16:24:39 +0000

If you want to know in just how big a mess we are in, do not bother wading through the Chancellor’s figures.

Instead, you should consult a fascinating report put out every six months by the OECD, a think-tank for all the rich countries.

Its latest Economic Outlook includes a prediction which nobody in Britain has picked up but which is extraordinarily important: in 2010, public spending will reach no less than 54.1 per cent of our economy.

The private sector — you and I and private firms — will spend just 45.9 per cent, which means that we will technically no longer be a proper capitalist economy.

And just in case you think these figures are plucked out of thin air, the OECD thinks public spending will already have reached 52.4 per cent of GDP in 2009.

To put all of this in perspective, public spending was 40.6 per cent of GDP when Labour was elected in 1997, falling to just 36.6 per cent by 2000 after several years of strong economic growth and Tory-inspired public sector spending plans.

It was around that time that Gordon Brown started to crank up spending, which began an inexorable rise during the boom years before exploding out of control when the economy ground to a shuddering halt in 2007.

Only five developed countries — France, Sweden, Finland, Belgium and Denmark - will have proportionally larger government sectors than Britain next year, and in every case only marginally so.

In stark contrast, the US government will spend 42.8 per cent of its economy next year, Australia 37.4 per cent and Korea 33.7 per cent.

There is plenty of evidence that big government nations suffer weaker economic growth and more subdued job creation over time once all other factors are accounted for.

The state spends money very inefficiently and diverts resources away from capital spending into consumption.

Our bloated government will also require massive tax hikes after the next election: the recent explosion in public spending in Britain has come from borrowed funds rather than from extra tax receipts.

This is unsustainable, as Alistair Darling, as well as the Tories know full well.

There is no doubt that the economy is slowly improving. But unless an axe is taken to public spending, an excessively large government will condemn Britain to years of high taxation, economic decline and general misery.

First Person: Don’t blame bonuses

Allister Heath — Thu, 15 Oct 2009 10:35:48 +0100

Passion is always the enemy of reason. This is true in politics as in everything else, and helps to explain why we have all got so excited about cracking down on bankers’ bonuses. “Wait a second,” I hear you say: “Bonuses paid out to greedy City boys fuelled the boom and bust and should therefore be capped, right?” That, after all, is the new consensus in Westminster and a view that resonates with a public thirsty for revenge.

Yet the trouble with all received wisdom is that it tends to be wrong — and it is no different in this case. There is very little rigorous academic evidence (as opposed to glib assertions by regulators or commentators) examining whether CEO pay helped exacerbate the crisis. But the little that exists suggests that bonuses and stock options played no role in the crisis. If you don’t believe me, take a look at a new paper by Rene Stulz and Rüdiger Fahlenbrach, both dispassionate economists with no axe to grind.

Their findings — based on a forensic, scientific examination of the performance of banks — demolish the claim that badly-designed or excessive bonuses made banks focus too much on the short-term and take exaggerated risks. They reveal that it didn’t really matter what banks’ pay structure was. Whether bonuses were low or high made no difference to their firms’ performance or to the degree of risk-taking they chose to engage in.

Their conclusion: bank CEOs misjudged the state of the world and made stupid mistakes. They would have failed whether or not the bonus and stock option system was in place. If CEOs had taken risks they knew were excessive, they would have sold shares ahead of the crisis. This did not happen.

In fact, CEOs increased their stakes and options in their banks in the run-up to disaster and were subsequently hammered. On average, the research reveals that bank CEOs personally lost $30m each in 2008.

Don’t get me wrong: I don’t feel sorry for failed CEOs. They made devastating errors. But the underlying cause of their madness was excessively loose monetary policy, idiotic international rules and a series of misconceptions, shared by the entire global establishment, about the way the economy works. Virtually everybody thought you could abolish risk by using complex derivatives and mathematical models. Most people were convinced US house prices would never fall. Regulators encouraged banks to reduce reserves to a bare minimum. All of this turned out to be dangerous nonsense.

There are plenty of important lessons to be learnt from this crisis. We must reform our economies and financial system to avoid another bubble. But we shouldn’t obsess with bonuses: banker-bashing makes good politics but useless economics.

There’s no need to break up the banks

Allister Heath — Thu, 23 Jul 2009 11:08:24 +0100

A few weeks ago, the received wisdom was that a good way to ensure financial stability would be to forcibly separate investment banks from retail and commercial banks. There was also discussion about imposing limits on bank sizes. Yet the Labour Party in its White Paper and the Tories in George Osborne’s response have now largely rejected those ideas.

The new consensus focuses on making all banks hold more capital, with giant firms forced to hold the most. Institutions which operate investment banks as well as retail banks may have to hold much greater reserves to insure against some activities, such as proprietary trading, that are deemed higher-risk. The thinking is that this would indirectly limit bank sizes and dangerous activities by making them too costly. While some of these proposals are imperfect, this move away from arbitrary break-ups and size restrictions is welcome.

Remember who went bust. Northern Rock, Bradford and Bingley and other bailed-out lenders were small.et they were deemed “too big to fail” and even a banking industry populated with corporate midgets would still be in line for a bail-out next time things go wrong. A belief that small is good makes no sense. Imagine how bad customer service would be if all banks were limited to 100,000 customers. There would be no competition. The 100,001th customer would be turned down and the rest treated like dirt.

Forcibly separating investment and retail banks would not have prevented a single bail-out anywhere. Governments stepped in to help both kinds of banks from going bust, arranging shotgun marriages in some cases. Literature shows that unified banking is less prone to collapse than artificially segmented institutions. America’s Glass-Steagall Act was the product of an attempt by the Rockefellers to raise the costs of their rivals, the House of Morgan, and made little sense even in the 1930s. Not all the new proposals are good. A small building society that lends vast amounts to volatile commercial property firms is riskier than a well-managed investment bank that does not engage in highly-leveraged trading. And even most proprietary traders pose less of a systemic risk than the average stodgy lender. But some common sense is now prevailing in the banking debate — and for such small mercies we should be grateful.

First Person: Crunch time is to come

Allister Heath — Wed, 27 May 2009 15:59:50 +0100

BELIEVE it or not but Alistair Darling may actually be right that the recession will be over by Christmas.

But before you start uncorking the champagne, it is important to realise that this doesn’t mean a return to the good days. Total 1930s-style catastrophe has been averted, partly by luck and partly as a result of governments flooding the economy with liquidity.

Yet we are still facing a hangover from past over-exuberance, a public sector in complete crisis, an urgent need to wean ourselves from ultra-low interest rates and profligate public spending and a business environment that has been robbed of its competitiveness. So even though the economy will cease shrinking at some point towards the end of the year, unemployment will continue to rise for months after that, house prices will remain depressed and the economy will stagnate for several years to come. From 2010 onwards, the UK will face terrible headwinds: the Bank of England money-printing will have to cease and higher taxes are likely to plug the massive black hole at the heart of Darling’s public finances.

So much for my caveats to Darling’s headline grabbing claims. He is right, however, to argue that the credit crunch is abating. Many companies now find it easier to borrow money in the markets. The banking system has been stabilised; there is almost no chance of any more large UK or US financial institutions collapsing. The stock market is up by almost a quarter, sterling is recovering and bond yields are down. Consumer price inflation is manageable at 2.3 per cent. Savers are being throttled but that, sadly, was to be expected. And all the output surveys now say the same thing: the rate at which the economy is shrinking is slowing down significantly.

The purchasing managers’ index (PMI) for private services rose to 48.7, close to the key 50 reading which denotes the return to expansion. None of this will boost the Labour government’s chances at the general election. There are always lengthy lags between the actual return to economic growth and the public’s perception of it. Companies will continue to lay off large numbers of workers well into 2010, and hundreds of thousands more homeowners are being pushed into negative equity.

The Tories, when they get to power, will be faced with a monumental challenge: rein in the budget deficit and put up interest rates without throttling the nascent recovery, reform the Bank of England and the FSA. And they will have to begin tearing up all the regulations and destructive taxes introduced by Labour to recreate a climate conducive to entrepreneurship, while downsizing the public sector.

Compared to this long list of thankless tasks, getting out of the credit crunch might look as if it was the easy bit.